Mutual Funds are one type of collective investment vehicle. Mutual Funds typically obtain money from investors, and use it to purchase securities such as company stocks, bonds, or other securities. The mutual fund issues shares to the investors, and the shares are valued as a pro-rata portion of the net asset value (NAV) of the Mutual Fund. The investors may redeem the shares for cash or for the underlying securities held by the Fund. The Mutual Fund manager may trade the asset securities from time to time in an attempt to improve the performance of the Fund's portfolio, or to ensure that the securities held by the Fund accurately reflect the Fund's overall investment strategy.
One problem with Mutual Funds is that the sale of securities by the manager may result in capital gains that must be distributed to the shareholders of the Fund, even though the investors did not sell their Fund shares. Many investors would prefer to defer the receipt of capital gains and the associated tax liability until they sell their shares of the Mutual Fund. Therefore, to reduce the capital gains tax liability for the shareholders, Mutual Fund managers typically sell relatively higher cost basis securities when sales are necessary to obtain cash to pay distributions or honor redemptions, or when positions are changed, such as during a portfolio rebalancing. As a result of many years of trading in a way to reduce the capital gains distributions to shareholders, the U.S. mutual fund industry has amassed embedded capital gains in the hundreds of billions of dollars. The unrealized capital gains in these Funds increase an investor's expected future capital gains distribution, making the Mutual Funds less attractive to investors. In particular, the embedded capital gains become a major liability in the event of large redemption activity. In addition, the embedded capital gains may adversely affect the investment decisions of a fund manager, who might prefer to reduce or eliminate certain stock positions but for the adverse impact of incurring a taxable gain on the sale of the position.
Another fund structure, the exchange traded fund (ETF), is able to hold securities over long periods of time without developing excessive unrealized capital gains. The ETF issues shares in a creation event by exchanging them for baskets of securities. When the ETF shares are ultimately redeemed for a basket of securities, the securities provided by the ETF may be those having a relatively low cost basis without having adverse tax consequences. This is because the exchange of the ETF shares for the basket of securities is deemed to be a like kind exchange that does not create a taxable event for the ETF. Similarly, the entity receiving the basket of securities receives them at a cost basis of the current market value.
One disadvantage of the ETF is that the ETF shares are created in bulk: the baskets of securities are typically valued in millions of dollars. While the resulting shares of the ETF are traded on an exchange, the creation and redemption events involve millions of dollars, making them unavailable to most investors. Furthermore, the ETF structure does nothing to address the problem of capital gains overhanging in existing mutual funds.
Consequently, an improvement is desired.